Share investor or trader? Beware the tax traps

One interesting thing about the ups and downs of the economy is the human response. Sure, everyone wants to reduce the tax they're liable for, in both good times and bad, but changing tactics mid-stream just to obtain a deduction or a lower effective tax rate can really raise the taxman's hackles.

When times are on the up for the economy, getting a positive return on your share portfolio can be almost commonplace. Where there is a tax break on offer, such as the 50% CGT discount on shares (or most assets held for investment purposes) held for at least a year, naturally anyone who can make that claim is going to.

But with a change of economic landscape, and the resulting difficulty of making a good return on shares (or more likely venture into negative territory), the temptation could arise to take advantage of the tax rules that pertain to someone who has a business of trading in shares. On offer in these circumstances is the enticing ability to deduct any losses (that are realised upon a sale) from ordinary income. A share investor who does not conduct a business from share trading cannot get an immediate benefit from the capital losses, which can only be offset against future capital gains.

The trouble is, the tax treatment in these circumstances is one of those either/or situations. An investor who has been happily dipping their toe into the sharemarket for years but then tries to claim status as a share trader once the water turns cold (without any discernible change in their pattern of buying and selling shares) will raise a big red flag in the Tax Office.

The Tax Office even issued a 'taxpayer alert' over the matter (which is basically its version of a wagging finger) and says it will be keeping an eye on people who 're-characterise' their activities from a share investor to a share trader. Typically, it says, these people will have claimed a CGT discount in previous returns but are now realising losses and want to be able to claim an immediate deduction for them.

Which is not to say that such a thing is impossible, provided that you begin to conduct a bona fide business of share trading. Many passive share investors, who find down the track that they have the nous for it, can indeed go on to make a living from trading, or at least conducting a share trading business alongside other activities. But the Tax Office's warning says it is going to carefully scrutinise these sort of claims to make sure they are in relation to a genuine business activity.

The Tax Office's definition of a share trader is someone who undertakes 'business activities for the purpose of earning income from buying and selling shares'. Frequency and volume of transactions factor into the assessment of whether there are genuine business activities.  The Tax Office also looks favourably on the existence of a business plan and records being kept in a 'business-like manner'.  The amount invested would also be a criterion but is not generally one of the more crucial considerations. However, it is important to know that the Tax Office considers all your circumstances as a whole and there is no set 'checklist'.

What the Tax Office is on the lookout for are activities that it says a reasonable person would regard as artificial and contrived. Examples are where an investor starts to buy and sell on a more regular basis, probably with small volumes ('window dressing'), creating a trading plan that has purportedly been applied for some time, which will probably state something about maximising profit (although shares sold will make a loss), and recording more time spent trading or more research accessed, where both activities do not change the overall value of transactions significantly.

An important consideration for the Tax Office is the 'intention' of the investor (that is, to hold the shares for long-term capital growth and then sell to realise that growth) and the trader (that is, to buy and sell the shares purely for short-term profits), and how these intentions can be evidenced down the track when it comes time to sell. This evidence of intention may include the factors mentioned above.

A taxpayer may be characterised as an investor for particular parcels of shares and as a trader for other parcels of shares.  So even if you are carrying on a bona fide business of trading in relation to most of your shares, if you have been treating one parcel of shares as a long-term investment (no trading, no routine research and monitoring, no frequent records of market movements) then that parcel of shares will be taxed as an investment asset when sold.

Conversely, a capital investor who spies a great opportunity and buys and sells one specific parcel of shares with a definite profit motive will be taxed as a trader in relation to that parcel of shares but as an investor in relation to all other shares.

Your characterisation as a share trader or an investor will be determined by a number of factors. There are details in the PDF which members can access.

Further reading:
Growth versus income
What's an asset class?
Compound interest
What a balance sheet will tell you

Last reviewed 10/08/2012

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